Sovereign Analysis /
Ethiopia

Ethiopia: Vast potential but growth model adjustment needed

  • Ethiopia has been the fastest growing economy in the world this decade, but growth will be hard to sustain post-Covid

  • Industrialisation hype not reflected in the data, and momentum is fading, with need to shift to private sector-led model

  • Still positioned to become SSA manufacturing hub with many potential catalysts. We recommend ‘Hold’ on Ethiopia 24s

Ethiopia: Vast potential but growth model adjustment needed
Hasnain Malik
Hasnain Malik

Strategy & Head of Equity Research

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Tellimer Research
3 September 2020
Published byTellimer Research

This note builds on concepts outlined in our recent Sub-Saharan Africa Manufacturing Scorecard to dissect Ethiopia’s growth model (see here for the full analysis). While Ethiopia has been the fastest growing economy of the past decade, we find its growth model to be fragile and in need of reform.

Over the past decade Ethiopia has achieved the highest growth rate in the world, averaging 9.6% per annum in real terms. Its growth model is inspired by China’s experience with state-led industrialisation, and is articulated in a series of 5-year Growth and Transformation Plans (with GTP II just concluding).

Ethiopia is well-positioned to become Africa’s manufacturing hub given its large and cheap labour force and rapidly growing/young population (Ethiopia’s population of 112mn puts it behind only Nigeria’s 201mn, with over 75% below the age of 34). GDP per capita is still low at cUS$860/year at current prices, but years of sustained growth are creating a burgeoning consumer class.

However, Ethiopia still lags on other major indicators of competitiveness, with an overvalued REER, high tariffs, infrastructural constraints, difficulty doing business, and limits on human and economic freedom.

We blend these indicators to create a composite rank of manufacturing competitiveness in Sub-Saharan Africa (SSA) across several categories (see here), with Ethiopia ranking as the most attractive country for “scaled and cheap manufacturing” and on a “balanced” basis (eg a simple average of all three indicators).

Widening the analysis beyond SSA, Ethiopia scores far behind China and India but is on par with Indonesia and Pakistan as a “scaled and cheap” manufacturer. While Ethiopia may struggle to wrestle global manufacturing market share from Asian competitors, industrialisation in SSA is more likely to be driven by the ability to serve domestic and regional markets. Ethiopia is well-positioned from this angle, and could potentially leverage regional success into a more globally competitive position down the road.

State-led growth model is unsustainable

Its impressive track record notwithstanding, it is unclear if Ethiopia will be able to sustain its growth momentum in a post-Covid world. The state has been the driving force behind Ethiopia’s growth, with public investment averaging 16% of GDP over the past decade.

Much of this has taken place off-budget, with SOEs dominating key sectors of the economy including telecom, aviation, energy, logistics, construction and finance. While private investment has stepped up to offset declining public investment over the past decade and privatisation plans are afoot in the former four sectors, state dominance of the economy continues to impede private sector development.

High levels of investment have also pushed public debt to 56.7% of GDP in 2019/20, c52% of which is external and c46% of which is owed by SOEs. That said, a positive growth-interest rate differential has caused debt to stabilise in recent years, driven by a highly concessional debt mix.

Existing debt carries a weighted average maturity of 13.5 years and an interest rate of 0.9%, with the interest bill consuming only c5% of revenue in 2019/20. While a hard stop in public investment is thus not required, sustainable long-term growth requires a shift to a more private sector-driven growth model (especially if the grant element of new financing continues to decline).

Much of Ethiopia’s debt is owed to China, with disbursements totalling US$14.1bn from 2006-19 (second to Angola in SSA) and a pipeline of US$1.44bn of undisbursed debt as of end-2019. While transparency has improved (see the finance ministry’s public debt bulletin), there is generally a dearth of reliable data in Ethiopia and on Chinese financing more generally. As such, the exact size and terms of Ethiopia’s outstanding debt to China are unknown, creating some uncertainty.

Special Economic Zones (SEZs) have been a cornerstone of Ethiopia’s industrialisation policy, with 6 private parks and another 16 state-owned SEZs. Of these 22 parks, 6 are currently operational, 9 are under construction, and 7 are in the planning/design stage.

The government has so far invested at least US$1.55bn in state-owned SEZs spanning over 5,700 hectares, with a heavy focus on the textiles, garments, and apparel sectors. SEZs have created 50,000 jobs to date, driven by the flagship Hawassa Industrial Park (HIP) and Eastern Industrial Zone (EIZ).

While anecdotes abound of Ethiopia’s success using SEZs to drive export-led industrialisation, this transformation is not yet reflected in the data. Exports of goods remain insignificant and are now lower than they were a decade ago in nominal terms, falling sharply as a percentage of GDP from 8.2% in 2010/11 to 2.3% in 2019/20.

Coffee and other agricultural products still dominate the mix, with non-agricultural exports remaining stagnant. Textiles & textile products and leather & leather products are the only major manufacturing categories to show up in the past six months, recording a paltry US$90mn and US$40mn, respectively.

However, it is admittedly still early days in Ethiopia’s industrialisation efforts, and it could take time for manufacturing exports to ramp up. With 16 parks still in the construction or planning phases, there could be a gradual boost in exports as these come online.

SEZs have undoubtedly helped attract high levels of foreign direct investment (FDI) over the past decade, averaging 3.4% of GDP annually (largely from China). While FDI has declined sharply in recent years, the IMF forecasts a sharp uptick to c4.5% over the medium-term.

In addition, Ethiopia’s development model could be yielding tertiary benefits such as skills and knowledge transfer and supporting infrastructure that will compound the impact of future investment and sustain its growth model over the longer-term.

On these points, the jury is still very much out. One survey of employees in the EIZ finds that 60% of local workers did receive training of varying quality and length but were not satisfied with the training provided and promotion opportunities within their current companies. Another survey of Ethiopia’s leather sector finds that knowledge transfer is limited.

Without effective transfer of skills and knowledge, Ethiopia will continue to depend on foreign (Chinese) investment to sustain rapid growth, and private sector development will be stunted as domestic firms remain inefficient and unable to compete in the international market.

On the infrastructure front there has been tangible progress, with the US$4.5bn Addis-Djibouti standard gauge railway (SGR) as the crown jewel. The SGR has cut the transit time from Addis to the Djibouti port (through which Ethiopia sends most of its exports) from three days to just one. However, last-mile problems plague the project and there has been limited tangible economic benefit from the project to date.

Ethiopia’s ease of doing business ranking has plummeted in recent years and progress has stagnated on other major competitiveness benchmarks, with seemingly little to show for past investments. While there is evidence that some of the SGR constraints are being dealt with (see here), it remains to be seen if Ethiopia’s infrastructure spending spree will ultimately serve as a boon to long-term growth.

Losing momentum, but there are positive catalysts too

Even before Covid, it seemed Ethiopia was losing some of its momentum. When PM Abiy Ahmed came to power in April 2018 there were some promising signs of liberalisation, including the release of political prisoners, an opening to private investment, and the signing of a peace deal with Eritrea (which won him the Nobel Peace Prize in 2019).

Some of that shine has since worn off, with Abiy delaying this year’s election for at least 12 months due to Covid (but the northern Tigray region still planning to proceed with elections in September), a new electoral law that makes it harder for smaller regional opposition parties, and the resumption of anti-government protests in the restive Oromia region prompted by the killing of a popular singer (to which the government has responded forcefully, with nearly 250 killed and 9,000 arrested).

That said, given the high expectations that accompanied Abiy’s rise, a tempering was inevitable. Looking ahead, there is still relatively low hanging fruit that can be seized to drive the reform process forward. Privatisation remains a key priority, with the government moving ahead with plans to privatise 45% of Ethio Telecom and the IMF forecasting privatisation proceeds of US$1.55bn over the next two fiscal years. Infrastructure development also continues apace, with Ethiopia launching a feasibility study for a new SGR project that would link Addis with Khartoum, Sudan.

Most importantly, construction of the massive US$4.8bn, 6,450 MW Grand Ethiopian Renaissance Dam (GERD) is now 75% complete. With installed capacity of c4,200 MW and an electricity access rate of only 40%, the GERD will be transformational, enabling Ethiopia to become a major regional exporter of power and providing Ethiopia’s burgeoning manufacturing sector with an ample source of low-cost energy.  

However, as we have previously written (here and here) there is disagreement between Ethiopia, Egypt and Sudan on the pace at which Ethiopia should fill the GERD reservoir. Egypt is the most water-stressed EM ex-GCC (see here), and the GERD threatens the steady downstream flow of water. Ethiopia has already finished the first stage of filling despite deadlock at recent UN-mediated talks (allegedly due entirely to strong rainfall), but failure to reach an agreement could cap GERD capacity in the future. In addition, the US suspended cUS$130mn of aid to Ethiopia this week over its decision to fill the dam without first reaching an agreement with Egypt and Sudan.

The National Bank of Ethiopia (NBE) also plans to modernise its policy framework over the next three years by introducing a benchmark interest rate and floating exchange rate. Coupled with plans to create a stock market authority by year-end, the introduction of a benchmark interest rate will enable a deepening of domestic markets and broaden financing options for Ethiopian corporates. Meanwhile, FX flexibility would help reverse years of REER appreciation and improve export competitiveness.

Lastly, Ethiopia’s membership in the Africa Continental Free Trade Agreement (AfCFTA) could be pivotal to its efforts to become a regional manufacturing hub. A domestic market topping 112mn customers and increasing connectivity to Africa’s growth powerhouse, the EAC, via expanding regional transport and electricity networks will make Ethiopia an attractive pan-African investment destination.

AfCFTA aims to lower or eliminate cross-border tariffs on 90% of goods across all 54 AU members, opening up a single market of 1.3bn people. The AfCFTA could take some time to make an impact (with the initial start date delayed from 1 July 2020 to 1 January 2021 due to Covid and the single market only expected to be fully operational by 2030), but will increase intra-continental trade and investment and help fill the void left by the expiration of AGOA (which grants preferential access to the US) in 2025.

Government must pass the baton for reality to live up to hype

Driven by a clearly articulated and ambitious state-led growth model, Ethiopia has been the star growth performer of the past decade both in Africa and globally. However, there is still little evidence of industrialisation in the data and Ethiopia’s growth model is not sustainable unless policymakers succeed in shifting the burden of development to the private sector.

Improvements to the business environment and institutions will go a long way toward unlocking the potential of the private sector. However, if Ethiopia relies on protectionism and follows the import substitution model that has failed countless times in SSA, then the private sector will remain moribund.

If Ethiopia instead relies on policies that promote international competitiveness – following the export-driven models of the East Asian tigers which promoted skills/technology transfer and local innovation by actively incentivising exports – then Ethiopia may be able to sustain its strong momentum and translate raw growth into bona fide economic development and advancement for its growing population.

While debt has remained sustainable due to strong growth and favourable terms of borrowing, institutional strength and data transparency are still lacking and if growth begins to fizzle then issues could quickly arise. Domestic politics is also a powder keg and if ethnic divisions turn violent then reform efforts could be delayed further (with the Tigrayan elections this month as a potential flashpoint).

Ethiopia’s lone US$1bn Eurobond (due December 2024) trades at a z-spread of c530bps, roughly in line with the average across all B-rated peers and slightly wider than fellow East African growth stars Kenya and Rwanda (which have stronger institutions and, in the case of Rwanda, lower debt).

We think Ethiopia 24s are fairly priced on a relative basis and risks are balanced. If Ethiopia is able to navigate the transition from a public to private growth model and industrialisation gathers pace, then it will continue to be one the best frontier stories out there. However, the transition will be difficult and if not undertaken then soaring expectations will eventually converge with a more subdued reality.